Dairy Processing - September/October 2024 - 75

calculation for Class I (except for extended shelf life milk);
update the assumed level of components in the milk and the
amount of fat captured in cheese; and update the regional
Class I differentials.
The first change, updating make allowances, is one of the
simplest and straightforward. Written into the FMMO formulas is a
fixed margin for dairy plants which hasn't been updated since 2008.
The costs of running a plant have increased since then, so make
allowances needed to be raised.
But with the FMMOs there is a fixed pool of revenue to split
between the farmers and the dairy plants. So if dairy processors
get a bigger margin, that effectively means less revenue left for
dairy farmers. The higher make allowances lower the Class I, II,
III and IV milk prices by $0.74 to $0.89/cwt. There is a push to
include language in the next Farm Bill that would require more
regular surveys of the cost of production for dairy plants to
keep make allowances updated over time.
The second big change is removing barrels from the cheese/
Class III calculation. Right now the cheese price used to set
the Class III milk price is a volume-weighted average of 40
lb blocks of cheddar and 500 lb barrels. Historically, barrels
traded at about a 3-cent discount to blocks with the spread
only varying by a few cents throughout the year. But in the
past five years, CME spot barrels have averaged 11.8 cents
less than blocks, and on a monthly basis have been anywhere
from 28.9 cents higher than blocks to 68.8 cents less. Since
barrels are averaging more than 3 cents below blocks, they are
effectively dragging down the weighted average cheese price.
That reduces the Class III milk price, which the farmers aren't
happy about.
The increased volatility in the spread also means the cheese
futures contract has become less efficient as a hedging tool for
buyers and sellers who are pricing only off of blocks or barrels.
So the proposed solution is to ignore barrels.
The NDPSR cheese price will only include blocks. Years
ago, when the spread was steady around 3 cents, this change
would not have had much impact on the Class III price.
However, because barrels have been relatively weak in the
past five years, removing them from the calculation would
have boosted the NDPSR cheese price by about 4.4 cents over
those five years, which would have lifted Class III by 42 cents/
cwt.
The third change is moving back to using the higher-of the
advanced Class III or Class IV skim milk prices to set the skim
portion of the Class I price. The primary goal of the FMMOs is to
provide a safe and consistent supply of fluid milk to consumers.
One way it does that is by trying to make sure the Class I price,
which is the price of milk going into a beverage product, is the
highest price in the market, so sellers will fill bottling plants
first. From roughly 2000 to 2018, the FMMOs used this " higher
of " calculation to try and keep Class I at a premium to the other
classes, but it makes it very hard to hedge Class I milk. In 2018,
the formulas were changed to use the average of the Class III and
Class IV skim prices, plus a fixed premium. That has worked well
for hedging, but the extreme volatility in Class III prices during
the pandemic meant that Class III was often above the Class I
price, so we are reverting to using the " higher of. "
However, there is a carve-out for extended shelf life milk
that will be priced based on the average of the III/IV prices,
plus a rolling differential.
The other change to the Class I price is an update of
the Class I differentials. Think of these like local basis for
Class I milk. They are highest in areas where there is a lot
of population but it is difficult/costly to produce milk. The
differentials are being increased across the entire country,
from about $0.50 across the Western US, to about $1.00-$1.50
in the Central/Northeast, and about $2.00 in the Southeast.
There is a push to include
language in the next Farm Bill that
would require more regular surveys
of the cost of production for dairy
plants to keep make allowances
updated over time.
Since this is primarily a local impact, calculations for
impacts to milk prices are not included in this analysis. But
it will serve to raise farm gate milk prices with the revenue
mostly coming from increased retail pricing.
The last proposed change is updating the assumed
component content of the milk and the assumed efficiency
of cheese plants. The changes effectively raise the Class III/
IV milk prices by assuming you can get more finished dairy
products out of the milk going into the plant, and therefore the
pool of revenue is assumed to be bigger than it used to be.
Editor's note: The trading of derivatives such as
futures, options, and over-the-counter (OTC) products or
" swaps " may not be suitable for all investors. Derivatives
trading involves substantial risk of loss. Past results are not
necessarily indicative of future results.
Nate Donnay is the Director of Dairy Market Insight at
StoneX Financial Inc. and has been applying his expertise
in large complicated systems and statistical analysis to the
international and US dairy markets since 2005.
DAIRYPROCESSING.COM | SEP-OCT 2024 75
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